Don't Write Off Inflation Threat

If you thought a decline in wholesale inflation might prompt the Federal Reserve to reconsider its interest rate strategy, you'd be wrong.

In December, the producer price index fell 0.7%, its biggest decline since April 2003, as energy prices declined 4.0% and food prices rose just 0.1% after climbing sharply in the wake of four hurricanes. Excluding food and energy, the core PPI gained just 0.1%.

Economists were looking for the headline rate to fall 0.2%, while the core rate was expected to increase by 0.2%.

Ordinarily, inflation numbers like these would provide some support to U.S. Treasuries. But bonds sold off and yields rose on Friday, as investors focused on hawkish remarks from St. Louis Fed President William Poole.

The yield on the 10-year note rose 5 basis points to 4.21%. Stocks advanced, with the Dow up 6 points at 10,511 and the Nasdaq up 6 at 2077.

According to news reports, Poole said the Fed could drop its plan to raise rates at a "measured" pace at some point in the future. So far, the bank has been raising interest rates in quarter-point increments.

Sherry Cooper, chief economist at BMO Nesbitt Burns, doesn't think 50-basis-point moves are on the cards, but she does believe rates will rise from a current level of 2.25%, saying inflation is trending higher, despite last month's data.

"Although inflation problems are not yet pounding on the door, they are steadily walking towards the front entrance," she said.

For all of 2004, the PPI was up 4.1%, a hair more than 2003. But core prices rose at a 2.2% annual pace, twice that of the previous year. In 2002, core prices fell 0.5%.

"With crude oil rebounding towards $48 a barrel recently, the pullback in prices last month looks to be a short-lived," said Cooper.

Over the past few months, analysts have become increasingly concerned about pressures in the inflation pipeline. In December, the core intermediate index rose 0.5% and was up 8.3% year over year. And while core crude goods prices fell 1.7% last month, they are still up 20.1% over the past year.

So far, however, higher crude and intermediate prices have not filtered down to the consumer, as manufacturers have absorbed the costs.

Other data released Friday added to the concerns about rising inflation. Industrial production rose 0.8% in December, double the consensus forecast, while capacity utilization jumped to 79.2% from 78.6%, well above economists' estimate of 78.9%.

Still, Ian Shepherdson, chief economist at High Frequency Economics, said the strength is a "bit of a mystery, given the softness in manufacturing employment." He believes the data may have been skewed by seasonal adjustments. "Either way, we doubt these sort of gains can be sustained in the first quarter," he said.

Lacy Hunt, chief economist at Hoisington Investment Management, said he is looking for inflation to actually recede in 2005, as the economy slows down because of higher oil prices and further rate hikes by the Fed.

High energy prices are "contractionary, not inflationary, even if they temporarily lift the core rate," he said. "They are only permanent if the Fed monetizes them by accelerating monetary growth."

Hunt noted that the rate of increase in such money supply measures as M2 and M3 dropped to a nine-year low in 2004. Inflation "should reverse sharply to the downside this year, and the multiyear low in the core inflation rate lies ahead."

The consumer price index for December is scheduled for release on Jan. 19.